NY futures continued their impressive run this week, with May gaining another 188 points to close 64.69 cents.

Since posting a contract low of 57.95 cents on January 23, buyers have taken control of the market, pushing values nearly 700 points higher in the process without allowing for any major setbacks so far. A look at the candlestick chart clearly illustrates the current dominance by buyers, with the market closing 13 out of the last 18 sessions higher than it opened.

A lot of trade participants seem to be dumbfounded by this strong showing, considering that global inventories have never been larger than in the current season, both in absolute terms and on a stocks-to-use ratio. However, what some traders tend to forget is that the NY futures market is a localized play that reflects primarily the supply/demand dynamics in the United States.

Until recently speculators and the global cotton trade projected their negative macro and cotton views onto the futures market by wanting to be short, at a time when US high grades were selling like hot cakes and basis levels trended higher. This led to one of those rare occasions in which speculators and the trade both had net short positions, leaving index funds as the only long. However, massive export sales during January finally tipped the scales and with the chart momentum shifting, speculators started to aggressively buy the market.

The latest available CFTC data tells us that speculators bought 4.7 million bales net in the two weeks between January 28 and February 10. Assuming that speculators continued their buying spree since then, we estimate total spec purchases at around 7.0 million bales since this rally began in late January.

There were a number of technical factors that triggered this massive spec buying, such as the breach of a 5-month downtrend line and crossing above moving averages all the way to the 100-day. With momentum turning positive, it not only sparked short covering but also attracted new spec longs to the party, which is evident from the fact that open interest has held up fairly well despite the ongoing March liquidation.

While specs were buying, the trade continued to increase both its net and outright short position. Between January 28 and February 10 the trade expanded its net short by 5.2 million bales to 7.2 million bales, while outright shorts grew by 2.1 million to 13.1 million bales. Even though some of these shorts may be against new crop, the trade seems to have its work cut out to liquidate the remaining current crop short position over the next four months.

The end of February typically marks a seasonal low and this has a good reason. By now most of the crop has transitioned from producers to merchants, who then proceed to sell their basis-long to mills during the remainder of the season. When merchants buy their cotton from growers during the early part of the season, they typically hedge the newly acquired cotton by going short in the futures market. However, from around this point forward the trade is usually a net buyer of futures, as short hedges get lifted when cash cotton is sold or mills fix existing commitments.

We therefore have a situation in which the trade is structurally set up to be a net buyer of current crop futures going forward, while speculators are interested in the long side from a technical point of view. With around 75 percent of total US supply already committed and still eight months to go until new crop arrives, we don’t expect to see a lot of pressure on May and July over the coming months.

The opposite is true for new crop December, where the trade is expected to be a scale-up seller as we head into the planting season, while speculators typically don’t play much in the back months, with the exception of some market makers. The above described dynamics are the reason why the May/December spread has moved from around 360 points carry to even since the beginning of the year and this trend is likely to continue.

So where do we go from here? With the March liquidation now basically behind us, we may see the market to pull back a bit and regroup over the coming weeks. Speculators have bought a lot these past few weeks and probably won’t keep this pace up, especially with momentum indicators in ‘overbought’ territory, while trade shorts in May and July will likely wait for dips before reducing their exposure. However, we don’t feel that this bullish move is over yet - it is just taking a breather!

With new crop hedging likely to intensify over the next two to three months, we feel that May and July have a good chance to invert over December by a considerable margin.